Monopoly Power Point Slides prepared by Andreea CHIRITESCU

Monopoly Power. Point Slides prepared by: Andreea CHIRITESCU Eastern Illinois University © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 1

Why Monopolies Arise • Monopoly – Firm that is the sole seller of a product without close substitutes – Price maker • Barriers to entry – Monopoly resources – Government regulation – The production process © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2

Why Monopolies Arise • Government regulation – Government gives a single firm the exclusive right to produce some good or service – Government-created monopolies • Patent and copyright laws • Higher prices • Higher profits © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3

Why Monopolies Arise • Monopoly resources – A key resource required for production is owned by a single firm – Higher price • The production process – A single firm can produce output at a lower cost than can a larger number of producers © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4

Why Monopolies Arise • Natural monopoly – A single firm can supply a good or service to an entire market • At a smaller cost than could two or more firms – Economies of scale over the relevant range of output – Club goods • Excludable but not rival in consumption © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 5

Figure 1 Economies of Scale as a Cause of Monopoly Costs Average total cost 0 Quantity of output When a firm’s average-total-cost curve continually declines, the firm has what is called a natural monopoly. In this case, when production is divided among more firms, each firm produces less, and average total cost rises. As a result, a single firm can produce any given amount at the smallest cost © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 6

Production and Pricing Decisions • Monopoly – Price maker – Sole producer – Downward sloping demand • Market demand curve • Competitive firm – Price taker – One producer of many – Demand – horizontal line (Price) © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 7

Figure 2 Demand Curves for Competitive and Monopoly Firms (a) A Competitive Firm’s Demand Curve Price (b) A Monopolist’s Demand Curve Price Demand 0 Quantity of output Because competitive firms are price takers, they in effect face horizontal demand curves, as in panel (a). Because a monopoly firm is the sole producer in its market, it faces the downward-sloping market demand curve, as in panel (b). As a result, the monopoly has to accept a lower price if it wants to sell more output. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 8

Production and Pricing Decisions • A monopoly’s revenue – Total revenue = price times quantity – Average revenue • Revenue per unit sold • Total revenue divided by quantity – Marginal revenue, MR < P • Revenue per each additional unit of output • Change in total revenue when output increases by 1 unit • Can be negative © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 9

Table 1 A Monopoly’s Total, Average, and Marginal Revenue © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 10

Production and Pricing Decisions • Increase in quantity sold – Output effect • Q is higher • Increase total revenue – Price effect • P is lower • Decrease total revenue • Because MR < P – MR curve – is below the demand curve © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 11

Figure 3 Demand Marginal-Revenue Curves for a Monopoly Price $11 10 9 8 7 6 5 4 3 2 1 0 -1 -2 -3 -4 Demand (average revenue) 1 2 3 4 5 6 7 8 Quantity of water Marginal revenue The demand curve shows how the quantity affects the price of the good. The marginal-revenue curve shows how the firm’s revenue changes when the quantity increases by 1 unit. Because the price on all units sold must fall if the monopoly increases production, marginal revenue is always less than the price. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 12

Production and Pricing Decisions • Profit maximization – If MR > MC – increase production – If MC > MR – produce less – Maximize profit • Produce quantity where MR=MC • Intersection of the marginal-revenue curve and the marginal-cost curve • Price – on the demand curve © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 13

Figure 4 Profit Maximization for a Monopoly Costs and Revenue 2. . and then the demand curve shows the price consistent with this quantity. Marginal cost B Monopoly price Average total cost A Demand 1. The intersection of the marginal-revenue curve and the marginal-cost curve determines the profit-maximizing quantity. . . Marginal revenue 0 Q 1 QMAX Q 2 Quantity A monopoly maximizes profit by choosing the quantity at which marginal revenue equals marginal cost (point A). It then uses the demand curve to find the price that will induce consumers to buy that quantity (point B). © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 14

Production and Pricing Decisions • Profit maximization – Perfect competition: P=MR=MC • Price equals marginal cost – Monopoly: P>MR=MC • Price exceeds marginal cost • A monopoly’s profit – Profit = TR – TC = (P – ATC) ˣ Q © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 15

Figure 5 The Monopolist’s Profit Costs and Revenue Marginal cost B Monopoly E price Average total cost Monopoly profit Demand Average total cost D C Marginal revenue 0 QMAX Quantity The area of the box BCDE equals the profit of the monopoly firm. The height of the box (BC) is price minus average total cost, which equals profit per unit sold. The width of the box (DC) is the number of units sold. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 16

Monopoly Drugs versus Generic Drugs • Market for pharmaceutical drugs – New drug, patent laws – monopoly • Produce Q where MR=MC • P>MC – Generic drugs – competitive market • Produce Q where MR=MC • And P=MC • Price of the competitively produced generic drug – Below the monopolist’s price © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 17

Figure 6 The Market for Drugs Costs and Revenue Price during patent life Price after patent expires Marginal cost Marginal revenue 0 Monopoly quantity Competitive quantity Demand Quantity When a patent gives a firm a monopoly over the sale of a drug, the firm charges the monopoly price, which is well above the marginal cost of making the drug. When the patent on a drug runs out, new firms enter the market, making it more competitive. As a result, the price falls from the monopoly price to marginal cost. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 18

The Welfare Cost of Monopolies • Total surplus – Economic well-being of buyers and sellers in a market – Sum of consumer surplus and producer surplus • Consumer surplus – Consumers’ willingness to pay for a good – Minus the amount they actually pay for it © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 19

The Welfare Cost of Monopolies • Producer surplus – Amount producers receive for a good – Minus their costs of producing it • Benevolent planner – maximize total surplus – Produce quantity where • Marginal cost curve intersects demand curve – Charge P=MC © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 20

Figure 7 The Efficient Level of Output Costs and Revenue Marginal cost Value to buyers Cost to monopolist Value Demand to (value to buyers) buyers Cost to monopolist Quantity 0 Value to buyers is greater than cost to sellers Efficient quantity Value to buyers is less than cost to sellers A benevolent social planner who wanted to maximize total surplus in the market would choose the level of output where the demand curve and marginal-cost curve intersect. Below this level, the value of the good to the marginal buyer (as reflected in the demand curve) exceeds the marginal cost of making the good. Above this level, the value to the marginal buyer is less than marginal cost. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 21

The Welfare Cost of Monopolies • Monopoly – Produce quantity where MC = MR – Produces less than the socially efficient quantity of output – Charge P>MC – Deadweight loss • Triangle between the demand curve and MC curve © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 22

Figure 8 The Inefficiency of Monopoly Costs and Revenue Marginal cost Deadweight loss Monopoly price Demand Marginal revenue 0 Monopoly quantity Efficient quantity Quantity Because a monopoly charges a price above marginal cost, not all consumers who value the good at more than its cost buy it. Thus, the quantity produced and sold by a monopoly is below the socially efficient level. The deadweight loss is represented by the area of the triangle between the demand curve (which reflects the value of the good to consumers) and the marginal-cost curve (which reflects the costs of the monopoly producer). © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 23

The Welfare Cost of Monopolies • The monopoly’s profit: a social cost? – Monopoly - higher profit • Not a reduction of economic welfare – Bigger producer surplus – Smaller consumer surplus • Not a social problem – Social loss = Deadweight loss • From the inefficiently low quantity of output © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 24

Price Discrimination • Price discrimination – Business practice – Sell the same good at different prices to different customers – Rational strategy to increase profit – Requires the ability to separate customers according to their willingness to pay – Can raise economic welfare © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 25

Price Discrimination • Perfect price discrimination – Charge each customer a different price • Exactly his or her willingness to pay – Monopolist - gets the entire surplus (Profit) – No deadweight loss © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 26

Price Discrimination • Without price discrimination – Single price > MC – Consumer surplus – Producer surplus (Profit) – Deadweight loss © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 27

Figure 9 Welfare with and without Price Discrimination (a) Monopolist with Single Price (b) Monopolist with Perfect Price Discrimination Price Consumer surplus Deadweight loss Monopoly price Profit Marginal revenue 0 Marginal cost Quantity sold Demand Quantity 0 Quantity sold Quantity Panel (a) shows a monopolist that charges the same price to all customers. Total surplus in this market equals the sum of profit (producer surplus) and consumer surplus. Panel (b) shows a monopolist that can perfectly price discriminate. Because consumer surplus equals zero, total surplus now equals the firm’s profit. Comparing these two panels, you can see that perfect price discrimination raises profit, raises total surplus, and lowers consumer surplus. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 28

Price Discrimination • Examples of price discrimination – Movie tickets – Airline prices – Discount coupons – Financial aid – Quantity discounts © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 29

Public Policy Toward Monopolies • Increasing competition with antitrust laws – Sherman Antitrust Act, 1890 – Clayton Antitrust Act, 1914 – Prevent mergers – Break up companies – Prevent companies from coordinating their activities to make markets less competitive © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 30

Public Policy Toward Monopolies • Regulation – Regulate the behavior of monopolists • Price – Common in case of natural monopolies – Marginal-cost pricing • May be less than ATC • No incentive to reduce costs © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 31

Figure 10 Marginal-Cost Pricing for a Natural Monopoly Price Average total cost Loss Regulated price Marginal cost Demand 0 Quantity Because a natural monopoly has declining average total cost, marginal cost is less than average total cost. Therefore, if regulators require a natural monopoly to charge a price equal to marginal cost, price will be below average total cost, and the monopoly will lose money. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 32

Public Policy Toward Monopolies • Public ownership – How the ownership of the firm affects the costs of production – Private owners • Incentive to minimize costs – Public owners (government) • If it does a bad job – Losers are the customers and taxpayers © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 33

Table 2 Competition versus Monopoly: A Summary Comparison © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 34